306 PART FOUR Imperfectly Competitive Markets

PRICE DISCRIMINATION-A MONOPOLIST'S METHOD

m l-- -- -- -- -- -- -- -- -- OF INCREASING PROFITS

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In this sectio n, we exam ine vario us types of price discr imina tion.
.

,. refer s to the charg ing of diffe rent price s for differ ent
-----
Price disc . .
qua~ tities of a commocti~•rn•~ati~n
ferent mark ets wlncli are'nofjusfflf~d1''y"'eb~nmf'ererices.By pfil-m
icm-g"pnc e"J Jr.10 _dif.
. tion, the mono polis t can incre ase its total reve~•ue u1scnnu
and erofits. We first exanu na.
· charg ing of differ ent price s by the monopolis~ _for differ
ent quantities sold and thne the
charg ing of differ ent price s in differ ent mark ets . ., .- ,
• •
' I
. .
;
en the

' t . ,....
· Charging Different Prkes for Different Quantities .
't

If a mono p?lis t could sell each unit of the co~ odit r

separ ately and charge the highest
price eac~ consu mer woul d be willI!)-g to pay for the comm
odity rather than go without i~
the mono polis t woul d be able to extra ct the entire consu
mers ' surplus from consumers.
This is calle d first-degree (perfect) price discrimina
tion. · - .
For exam ple, in Figur e 10.10, the .cons umer ~oul d be
willing to pay LRZO ($22.50) ~
for three units of the commodity. Since he or she only·
pays I?ZOF ($18), this consumer's
surpl us is I.RF ($4.50). If the· mono polis t, howe ver, charg
ed $8.50 for the first unit (the
highe st price that this consu mer woul d pay rathe r than
foreg o entirely the consumption of
the comm odity ), $7.50 for the secon d unit of the comm
odity, and $6.50 for the third
unit, then the mono polis t woul d recei ve $22.5Q. (the
sum of the areas of the rectangles
abov e the first three units of the comm odity ), there by
extra cting the entire consumer's

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9
• I ; \
8

6
F--

FIGURE 10.10 First- and Second-Degree Price Dlsalmlnatlon

Since the consumer Is willing to pay $22.50 for three units of the
commodity, but only pays $18, this consumer's surplus is $4.50. If 3
the' '
monopolist charged $8.50 for the first unit, $7.50 for the second,
$6.50 for the third, it would receiVe $22.50, thus extracting the entire
and .
1

•
consumer's surplus. This Is first-degree price discrtw1nat1on. If · ·
the_ monopolist set P = $ 7 fte first two units and P = $6 for
additlonal units, It would sell three units and extract $2 of the' '. · ·
consumer's surplus. This Is second-degree price discrimination. z
o· . 1 . 2 3
(
 CHAPTER 10 p ·
nee and Output Under Pure Monopoly 307
surp lus from this cons ume r 9 The 1
or-n othi ng offe r to the con~um r~s: t wou
ld be the same if the monopolist made an all-
$22. 50 or'n one at all. er eit er to purchase all three units of the com
modity for
be able to prac tice first-de re . .
mus t ) know the exac t sh . . .
f g e pnce discnmmallon, however, the
the h g est pric e that 0 monopolist
h ao; each cons ume r's demand curve and be able
ity and (2) be abl t eac an ever y cons to charge
, e o ume r would pay for each unit of the commod
mod ity at d prev ent arbit rage • -
. . , or someone purchasm .
Ev "f thi ecre aSm g P?ce s and reselling some g man y umts of the com-
of the units to others at higher prices.
Then ~ s were p~ss ible, it wou ld probably be proh
ibitively expensive to carry out.
us, r st-deg r~e pnc e disc rimi natio n is not
very common in the real world.
Mor e prac tical and com mon is second-degre
refe rs to the chargm·g of a :" e (multipart) price discrimination. This
. unuo rm pnce · . for . . of
per umt a specific quantity the commodity . ,
low er pnc e per unit for an additional batch a
or block of the commodity, and so on. By doin
so, the mon opol ist will be able to extract g
part, but not all, of the consumer's surplus. For
ex~ ple , in Figu re 10.10, the monopolist coul
d set the price of $7 per unit on the first two
umts of the com mod ity and a price of $6 on
additional units of the commodity. The monopo-
list wou ld then sell three units of the commod
ity to this individual for $20 and extract $2 from
the tota l cons ume r's surplus of $4.50. In gene
ral, this is also diffic~lt to do because it requires
that the mon opol ist be able to identify each
consumer's demand curve and prevent arbitrage.
Seco nd-d egre e pric e ·discrimination is often
practiced by public utilities, such as electrical
pow er com pani es.

Charging Different Prices 1n Different Markets 10

w
Cha rgin g a diffe rent pr_ice _giff¥rem.,w,wk~
For simp licit y, we will assu me that there
§, is called third degree pric~ ~cri min atio n.
are only two markets. To maxnmze profits, ~e
mon opol ist mus t prod uce the best level of
output ~d s.ell ~a~ _o~mut in th~ two !11¥k~ts
such a way that the mClfginal ~y,enue...of.. -1:° _
theJas~..Jllllt.sol~uua~-m~k et,1s,,th ~. This
will requ ire the mon opol ist to sell ~e ~orn
mod1ty at a higher pnce m the market with the
less elas tic dem and. This'is show n mFi gure
-10.11. . .
The left pane l of Ffgu re 10.- 11 show s D and
1 MR 1, which are, respectively, the _m~-
corr espo ndin g marg inal revenue curves face
ket
. dem an d and the d by the monopolist m
The mid dle-p anel show s,the D2 and MR 2 1or " h
t e seco n ct mark e t F the
the first mar ket. , fD d D and from MR1 . and MR2, we get D and . rom
h ·· ntal sum mati on
onz o ° 1
, olist ) an
2
in the righ'
MR for the
t pane l. We sum horizontally D1 an d D2, an d MR
firm as a who le (mo nop the com mod ity in and obtain extra revenues 1

an d M R beca use the firm can se 11 from both

2, . _
5 MR = MR, and until Q = 5, D1 = ·
D
mar ~ets . Not e that unti l Q - 2fo; the ~on opol ist is seven units and is given _by
.
The best leve l for outp ut the pomt
(MC) intersects the ·firm's total margmal reve
whe re the fi rm ' s marg inal cost curv e nue
. E in the righ t panel). To maxirmz . . al fi th
curv e (MR) from belo w (pom t . e tot pro _ts, e mon ~p-
f the comnmdity in market 1 (given by
olist shou ld then sell . four u~1t~ othree pomt
units in market 2 (given by point E2 in the rnid-
E1 in the left pane l) and the rem ~:~ =
MC = $3 (see the figure). If the MR fo~ the
la~t
dle pane l) so that MR I =
k!R2 -
odity sold m one mar e
k t were different from the MR of the last urut
sold m
unit of the com m
1 to the area under the demand curve between
---- . th:----:nsumer is wiUing to pay an _amount zero
9 Note that e co equam odity. This is equal to the area of the rectangle
. ~ the first unit of the com
and one on t he horiz.
ontal axis or •
nuno dity in Figur O IO
e I . . . · 12
abov e the first unit of the co .
. d'
f price discriminatton usmg ru ,men
tary calculus, see Sectio n A. of the
. 1 prese ntauo n o
10 For a math emat tca th d of the book.
Math emat ical Appe ndix at e en
 Imperfectly Competitive Markets .
30 8 PART FOUR
$
Fir m
$
l.....__\...,, 11 Market 1
.....

' $ Ma rke t 2

7 -- - -; -- - 6
6
6
5.3g
4.5 0 4
D2
. ,;✓.' - -- -- 3 --- · 3 -- -- -- -- --
--
,; 3 -- --- -- -- -- MR
, MR 2 '
"'7 ,
• I
.
. . MR1 ·' I
I
_, 7 Q
2.5 5
0
., ... ; 4 5 Q1 0
2.5
. 0 and curv~ faced by the
Thir d-D egr ee Pric e Dis aim inat ion 0 1 in the left panel is the dem
AGURE 10.11 curve). D2 and MR2, 1n ~he middle
(wit h MR as the corresponding marginal revenue
mon opo list in ma r~l 1 get the D and MR curves for
2. By sum min g hori Zon tally 0 1 and D2, and MR1 and MR2, we
panel refer to mar ket MC curve intersects
righ t pan el. The bes t leve l of out put is seven units, given where the
the monopolist in the Q = 4 at P = $ 7 in market 1 and
curve w. To max imiz e tota l profits the monopolist should sell
· ·the MR from belo {point Zin the right
5o tha t MR = MR 2 =M R= MC = $3. With AC = $4
. : . Q ~ 3 at p = $4. 50 in ma rket 2; 1
' · · -
are $13.50. · ·
· ' panel), the monopolist~ total profits l •
- • •, '
~ , r • .1 .' • ... ; •

~ by redistributing
rea se its tota l rev enu e and pro fits
~ • - ' f • • : !
olis t cou ld inc
the hig her MR unt il MR 1 = MR2.
the other ma rke t, the mo nop
m the ma rke t wit h the low er MR to the ma rke t wit h
·. • 1 • sale s fro
P, = $7, for eac h of the fou r uni
ts of the com mo dity sold
nop olis t sho uld cha rge
• ' •• The mo ts of the commodity in
1
P , · $4. 50 for eac h of the thr ee uni
· • • •

• in market 1 (point R on Di) and tha t the price is

(po int Vo n Dz) . Tiri s ass um es tha t res ale is not pos sib le. No te
· ... , •• . · - . market 2 of the mo nop olis t would
in ma rke t 1, wh ere dem and is less ela stic . Th e tota l rev en~ e
• • _ . hig her
8 from _se llin g fou r uni ts of the com mo dit y at P $7 in ma rke =
t 1 plu s $13.50
·. be $41.5? ($2 Wi th tota l costs of $28
· · from se ~g thre e um ts of the com mo dity at P $4. 50 in ma rke t 2). = ns a profit
= $4, giv en by poi nt Zin the rig ht pan el), the mo nop oli st ear
' (seven umts at AC the mo nop olis t sold
3 (the tota l rev enu e of $4l .5O min us the tota l cos ts of $28 ). If
·. of $l .50 Wo n Di n the right panel)
lev el of ~ut p~t ~f ~v en uni ts at the pri ce of $5. 33 (po int
· :e :~ t the monopo-
s (1.e ., if it did not pra ctic e thir d deg ree pri ce dis crim ina tion ) '
. list ulmardket
ear n a profit of wz - $1 ·33 per urut . ~ pnc e of $5. 33 min us the average cost
• (th .
. wo
of $4) and $9.31 in tota l (the $I3 3 uni ts sol d) as compared
ri
•' I

~ro ~t ~r ~ru t tun es the sev en

I

. wit h $13 .50 wit h thir d de utio n of s~es

ma r1r e:C ::d C:- di~ cnn una tion . An y oth er out put or dis trib
between the two for the monopolist.
val id for thimi larl y lea d to low er tota l pro fits
. ·... . This typ e of ana lysi s is
g run as we ll as for the sho rt run
. 11
• · . . . . e lon
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·I ·
11 ; . ·. · · · - (he
If the monopolist knows the · e clasucrty of demand ti th • m
ity
. the· two markets it can deternun e
pnc commod
price t.o c""
d
- ·
..... ., m each marl
at tbc eo of
6
lbe book.
cet to maximize or e
total profits by utilizing formula
[5.8]. See Pro blem '1O with the answ er
.
.
 CHAPTER 10 pnee
· nd
a Output Under Pure Monopoly 309

Flfinn able to practiee third-de

to be
be met. Frrst, the firm must h
. . . . .
gree pnce discnnunation, three conditions must
taker). econd the firm must abve.1_ b~me monop.oly_p o.we!J!,e., the firm must not be a price
.. . ,... e a e to keep the two k ts . .
~age. Jbird, the pti£:e elasticity of demcmd t'" -.~ ~_.:......!~E.tl_:.~ as to avotd,.¥bl-
the two markets All three di . •,- •-· or tliecommodity·or service must be different in
. . con tions are met in the al f 1 . . ;\p or example, - ....
electri-
cal power companies can set . . s e o e ectnc1~
industrial use of electri . . :nces (subject to government regulation). The market for the
each production lant
use is higher than~or h
:1 ~s ept separ~te from -~ at o~ household use by meters installed in
ome. The pnce ~last1c1~ of demand for electricity for industrial
h . . ousehold use because mdustnal users have better substitutes and more
c mces available (such as generating their own electricity) than households Thus electn·cal
power comparue~ · usuallY charge lower pnces .
. to mdustrial · ' /
users than to households.
Note that without market power the firm would be a price taker and could not practice
any form . of pnce · · · n. If the firm were unable to keep the markets separate,
· di_scnmmatio
users m the lower-pnce d market could purchase more of the service than they needed and
rese~ som~ of it i~ the higher-priced market (thus underselling the original supplier of the
service). Fmally, 1f the price elasticity of demand were the same in both markets, the best
that the firm could do would be to charge the same price in both markets.
There are many other examples of third-degree price discrimination: (1) the lower
fees doctors usually charge low-income people than high-income people for basically
identical services; (2) the lower prices that airlines, trains, and cinemas usually charge
children and the elderly than other adults; (3) the lower postal rates for third-class mail .-
than for equally heavy first..:class mail; (4) the lower prices tfiat producers usually charge
abroad than at home for the same commodity, and so o~
Third-degr ee price discrimination is more likely to occur in seryice industries tb90 in
manufactur ing indu~ ..s....because it is more difficult (often impossible) for a consumer to
purchase a service-in the low-price market and resell it at a higher price in the other mar-
ket (thus underminin g the monopolist's differential pricing in the two markets). For
example, a low-incom e.person could-not possibly resell a docto~'s visit at a higher fe~ to
a high-incom e person. On the other hand, if an eld~rly pe~son we~e charged a lower pn~e
for an automobile , he or she could certainly resell 1t at a higher pnce to other people. It 1s
supermarket's charging of $0.95 for two bars of soap and k$0.50 for one bar
no t c 1ear that a ation however • 1 , · · k
• · di · · because the supermarket saves on c er s tlme m ·marth -
1•s pnce scnmin •
, on cashiers' , b'll That 1s, e
h d. nd time in ringing up customers 1 s. •
mg the mere an 1se a k .
. f d·a nt prices to different consumers in different mar ets 1s not pnce
chargmg o 1uere . .
. . . . 'f the different prices are based on different costs.
d1scnmmat1on 1